The Changing Nature of Business in the Construction Industry
The nature of the construction industry is changing, and a major driving force for this change is what is often referred to as the commoditization of construction services resulting in margin compression for construction firms. Whether evolutionary or revolutionary in nature, these forces will drive some contractors out of business. Those who thrive in the next generation will not just survive; they will master change and remodel the industry.
A few years ago, we heard everywhere about the “Perfect Storm” that had come down hard on the economy and tossed the ships of the construction industry around like so many toy boats. We suddenly – it seemed sudden, anyway – learned the housing market was overbuilt, oversold and over leveraged. We learned, whether we wanted to or not, about short selling, subprime lending, hedge funds, bundling, credit default swaps, margin calls, quants, derivatives and Ponzi schemes, all with the amazing abilities both to make money and to make money vanish into thin air. The bubble was so big, it covered the globe. Until it burst, most of us thought things were going well- we were in the “good old days” of the construction industry In hindsight, we were watching the buildup of forces that would unleash an economic tsunami, the Perfect Storm that left the Great Recession in its wake. If that was not enough, there were real tsunamis, earthquakes and major storms to deal with that cost lives and the global economy untold billions of dollars, yen, Euros and Yuan. To this economic epic, add political grandstanding and deadlocks, leading to even greater uncertainties in the markets and the future of global currencies and debt. Real-life experience in this economy seems more than enough to put action movies out of business.
If the story of the beginnings of the Great Recession are starting to sound like modem history, that is a good sign. Nonetheless, we are still living through it. The forces that ripped through the economy will continue to reverberate across the globe for some time to come. The world is forever changed. Yes, there are signs that things are improving, but we still have continuing high unemployment despite more people finding jobs. Banks are making loans again, but only to the best, lowest-risk customers with more stringent regulations and equity demands. The construction industry has shrunk 30% or more since its highs in 2007 due to loss of employees and less avail able work. Some companies have gone away; most have just gotten leaner and meaner in order to survive a highly competitive, tight market. The economic outlook calls for continued slow growth, in large part because most of the problems that made headlines in 2011, including the global debt crisis, as recent downgrades of Euro-zone credit ratings indicate, are still with us in 2012. Global financial markets are still precarious.
Owner organizations have also downsized their internal engineering and construction departments to accommodate more moderate corporate expansion plans as we discovered in the “FMI/ CMAA Eleventh Annual Survey of Owners,” 2010:
- More than half of all owners say they expect to either resume hiring in 2012 (10%), 2013 or later (14%), or never (28%).
- 28% of responding owners say they expect never to resume hiring. However, a significant minority do report plans to hire in 2010 (20%) or 2011 (22%). In the view of more than half of all owners, diminished staff resources are a permanent condition.
The result is that owners expect greater support from construction service providers, and they want the lowest price possible. That often means changing construction delivery methods:
- 55% of owners describe their approach to construction execution as “most like design-bid-build”.
- 24% said they took “a blended approach,” and about 18% said their approach was “most like design-build.”
- For large projects, however, the dominance of design-bid-build seems to be eroding, with only 47% of owners reporting using that method, compared to 24% reporting a blended approach, and 21% saying their approach was most like design-build. (Ibid.)
For owners, it is a buyers’-market bonanza where purchase of construction services is beginning to resemble online purchasing, like Amazon, Groupon™, eBay® or even the Chicago Mercantile Exchange. The information revolution has given purchasers more information than ever, and large owners are more sophisticated, with a ton of technology at their fingertips. Thus, there is growing pressure to look at construction as a commodity purchased on the open market for the lowest bid.
Is it the future of construction to battle it out in bidding wars or to become another product sold on eBay? Likely not in the near future, but there is a growing sense that the road out of the Great Recession will not land us back in some imagined “normal” state. The Perfect Storm and its aftermath have changed the course of the future for the world and for construction. We are not going back to the market of 2007. There are a number of economic forces coming together to put increasing pressure on margins and, in many cases, change how construction gets done. Whether one thinks of these changes as evolutionary or revolutionary is academic, but to ignore change in favor of “doing what we’ve always done” is naive and dangerous for a company’s continuing existence.
The industry upheavals have put a severe strain on contractor profit margins, which in better times typically range between 2% and 5%. More recently, studies have shown sharp drops in profitability for contractors, approaching a meager 1% , and negative numbers becoming more frequent. Those results are unsustainable for the health of the construction industry. The question at this point is not whether or not contractors will go out of business in this economic environment, but how many and how soon? Then there is the other side of the coin; even in these tough conditions, there are contractors making money. How do they manage this counter-trend? For one thing, they are firms that are not content to sit on the shore and watch the world go by.
Is Construction a Commodity?
Although we don’t expect to see construction procurement go the way of eBay anytime soon, there are already reverse auction sites for construction procurement. To say the least, this practice has not been endorsed by major contractor organizations. Savings to owners have not been demonstrated, and there are a host of problems associated with the open-bid approach. Construction is different from products and services sold online. Most contractors, and even most owners, would say construction services are not commodities. Buildings and the construction process are too complex to be considered commodities. Construction is a professional service requiring different mixes of skills, capabilities and technical specialties that make each service provider unique.
A commodity is defined as a product or service that is relatively the same no matter the source or provider. Commodities are “fungible”; that is, one product can be exchanged for another. Most commodities are traded on an open market where the price is largely decided by supply and demand. (However, speculators temporarily boosting demand or suppliers reducing output until the price goes up can artificially influence both supply and demand, for instance.)
The contractor’s perspective includes the fact that each contractor is unique with services differentiated from its competition. For instance, contractors have different experience levels, safety records, abilities to get the project built faster, or better customer relationships and communication systems, to name just a few areas of differentiation. The owner looks at the project and says, “Here are the bid package and drawings.” The contractor that can deliver on the details of the contract for the lowest price wins the job. That simple, right? No, of course not, as anyone who has entered into a construction contract will tell you. Otherwise, it might look more like a simple purchase order -x bushels of wheat at current market prices for May delivery:
One major area of choice for owners with a project and contractors offering services is seen in · the area of delivery methods. The choices and variations of delivery methods have increased considerably over the last two decades. If low bid/design-bid-build appears to be more prevalent these days, it may have more to do with lack of information or just the idea that owners are going to take advantage of a desperate contractor market and push for the lowest price. Multiple options exist, including design-bid-build (D/B/B), design-build (D/B), construction manager (CM), construction manager-at-risk (CM/GC) with a guaranteed maximum price, or, the more recent addition, integrated project delivery (IPD). Optimally, the owner will make an educated choice to address the specific need.
One of the reasons there are so many delivery methods available is that the more traditional D/B/B approach was not yielding the desired results. D/B/B has a tendency to be contentious, pitting owner against contractor as one tries to outsmart the other, often ending in court cases. This may not be the situation with every D/B/B project, but the current cut-price market has greater potential for contentious change orders, poor quality and unsatisfactory results.
Over the past few years, we have heard contractors and even some owners caution against blindly focusing on low price for construction. Responding to our recent survey on construction delivery methods, one contractor commented:
Bidding has become stupid with contractors pricing at extremely low levels. Why? To keep their men working and maintain cash flow.
Owners are very aware that this is a good time to get the lowest price for projects, but some are cautious:
Everyone is doing more with less, less human resources as well as lower profit margins. The economy has produced a great bidding environment for owners relative to pricing; however, it does not come without risks- mainly quality of work and subcontractor solvency A significant value is placed on contractor pre-qualification with the hopes that the subcontractors selected will last throughout the project. (Owner Project Manager, large university system, responding to the “FMI/CMAA Eleventh Annual Survey of Owners”)
According to William Terrasi, director, enterprise project management, DTE Energy, just getting more bidders does not assure getting the best contractor for the job:
You’ve got to be careful what you wish for. To put it simply, sometimes you are exposed to a real gem that you never knew about, and other times you get a lot of pretenders, and we don’t need more pretenders. Whatever their niche was, they need to stay there. (FMI “Win/Win Project Delivery”)
Despite what most owners know by experience and, for many, what their favored delivery method would be, we have found more owners, at least temporarily, have returned to something more like D/B/B. According to our 2010 survey of owners, nearly 55% have gone that way for project execution. (See Exhibit l) However, when asked which construction procurement method they used, nearly the same amount selected low bid compared to select bid, and 29% still chose negotiated project procurement. (See Exhibit 2) These figures indicate that the majority of owners still recognize some differentiation among delivery methods and contractors. Low-bid procurement does not guarantee best value or even lowest price at project completion.
The pressure from owners to treat construction procurement as a commodity continues in structures that are characteristically not as complicated to build, have more or less standard designs and prototypes, and many builders have the capability and expertise to build them, thus making the market highly competitive. Examples include:
- Housing (residential and multifamily)
- Chain stores/retail
- Office buildings (excluding high-rise, skyscraper)
To say that the above list more closely fits the definition of a commodity is to say all housing, warehouses, etc., are the same or nearly so. However, building structures in each of these categories can have a wide range of special designs and features. Owners can also have different needs, like scheduling concerns or site requirements. Some contractors will be more experienced and capable than others, depending on the special requirements.
Even those owners wanting to treat construction services as commodities when in the purchasing phase want unique buildings, something that sets them apart from the competition. That’s the case for community schools and housing. Commercial owners want their buildings to be differentiated from the competition to offer their own unique experience or support their brand in some way. But need and price can alter some of these differentiators. Sometimes a good, serviceable building will suffice when a community is facing a sharp increase in student population without a significant increase in tax income. A store chain may be able to modify vacant buildings to suit its needs. Companies keeping expenditures low may decide that this isn’t a good time to build a building with marbled halls and customized offices. In tough times, owners may be willing to modify their needs and desires in order to get the building at a price they feel is affordable. First, they want it all, and they will try to get it by looking for the lowest bid from contractors.
Construction projects that would not readily fit any description of commodity might include those that are characteristically complex, have unique designs, include innovative technology, present difficult building conditions, or are mission-critical or significantly large in scope, such as:
- Medical buildings
- Research facilities
- Power plants and other utilities
- Oil platforms
- Chemical plants
- Concert halls
- Water and wastewater plants
- Highways and roads
Building types not as likely to be treated as commodities are still subject to owners looking for the lowest bid, but the bidders must be pre-qualified. Savvy owners are looking for best value. Among the reasons for this include the cost of poor quality and missed schedules for large projects. If a contractor fails in the middle of a stadium or power plant project, the cost in lost box office receipts or production is extremely high. Structure failure in any of these projects is potentially catastrophic. The risks are too high for owners to take the chance that the lowest bid is not the best-qualified bid. Owners building most any type of project should feel the same way. But when times are tough, they are willing to take the chance that the contract will protect them from risk; and contractors hungry for business will cut prices even at a loss.
Reducing cost by soliciting the lowest bid in a design-bid-build delivery method is not the only way owners are seeking to reduce the cost of construction, but it still predominates, according to comments received from panelists of FMI’s Nonresidential Construction Index Report. In the first quarter of 2012, we asked panelists what they are seeing owners do to reduce and control project costs. There are a range of things owners are doing to reduce costs, but most of the comments from construction industry executives focus on changing delivery methods and pressuring contractors to get the lowest price possible. Among the most questionable methods, several contractors note the increase of bid shopping. The following is a sample of comments on what owners are doing to control costs:
- Cost is not an issue to owners. Bids are coming in well below estimates due to excessive competition and lack of backlog from some contractors.
- Rebidding multiple times to shop contractors.
- Bidding in the street so they get low numbers.
- Becoming CMs themselves and using multiple primes.
- Change comes slowly in the Northeast. We are seeing more competitive lump-sum bidding and less CM-at-risk.
- It has become a much more mixed result where certain owners who are more inclined to seek true life-cycle value are staying with or going back to the value proposition and quality-oriented contractors who can demand a fair margin on the work. Otherwise, there are still many developers and owners who know that contractors are desperate; and if they look diligently, they can get these contractors to compete to get all subs driven to a bottom number and the GC themselves to bid with a zero fee, sometimes less, in hopes they can bargain more from the suppliers and subs after award. This has resulted in GCs defaulting, and I suspect we will see more of both GCs and trade contractor defaults this year. Buyers, beware!
- The greatest frustration is that there appears to be only nominal consideration of the risk they are accepting when they award work to substandard trades. The concept of paying for value and workmanship have gone out the window, and low price wins 99 out of 100 times.
- We are seeing the public sector in our areas finally get onboard with early selection of the CM/GC.
- We have seen a huge increase in bid shopping.
- We have seen several clients that have traditionally hired CMs for CM-at-risk work, based on qualifications only, go to a system where qualifications are the first step. Then, providing fixed fee and general conditions percentages or lump-sum amounts is ultimately the deciding factor. Others are hard bidding work vs. selection and negotiation.
- We are seeing heavier use of BIM and prefabrication.
Is the construction industry returning to the dark ages where relationships, collaboration and the idea of value are retreating into the shadows? Certainly, contractors and owners are taking on more risk when low price is the only criterion for awarding the contract. As commented above, “Buyers, beware!” We should also add, “Sellers, beware.” Owners may be buying a Yugo when they wanted a Ford or a Lexus. The result is potentially a great increase in legal disputes and contractor bankruptcies, which is good for the legal sector, but not the best construction delivery process.
Return of the Master Builder Concept
Not all owners are moving or regressing to design-bid-build or low-bid methods of procurement. According to our recent NRCI survey, the move to design-build delivery is more prevalent; yet owners still push for the lowest price. However, owners are also more willing to consider alter native materials and methods to save money, especially as material costs have continued to rise throughout the recession-one more concern that reduces profit margins for contractors. Interestingly, there is another trend, especially for midsize and smaller contractors; owners are involving CMs and contractors earlier on in the project in the design or even pre-design phase. Along with the move toward integrated project delivery (IPD), some have likened this to a modem version of the ancient Master Builder concept.
The use of qualified owner project managers (OPM) to serve as clerk of the works-mandated on large public projects in Massachusetts, for example-adds an upfront cost that increases ini tial price to reduce final project cost. Further, the OPM challenges the contractor to validate all elements of a project budget, the contractor’s margin and the project cost structure. The savvy contractor is learning to anticipate project audits, pre-audits and onerous review of margin opportunities. The construction industry is challenged to come to terms with an acceptable level of risk and return for the contractor to preserve long-term industry health. Without attractive margins and profits, ultimately the financial health of contracting is in question. There are limits to the margin compression squeeze being applied by buyers of construction services.
In response to the need for cost certainty and best value, the industry has developed robust and sophisticated pre-construction services. The delivery of high-quality, professional pre-construction is mandated for the owner to attain project objectives at maximum value and the E&C providers to earn respectable margins. Onerous, abusive and punitive contractual terms and pricing schemes are unsustainable. Effective “free markets” must arrive at an equilibrium.
The real risk in the low-bid squeeze play is that, even though owners are taking advantage of a highly competitive market, those providing construction services will play the game and do the best they can to make up for winning the bid with negative profit projections by cutting comers, increasing the cost and number of change orders and billing for any extras possible. Some cost recovery methods will be legitimate, some not, but the contractor wants to make money on the project. Contractors that do not play the game well risk going out of business. This type of atmosphere of contentiousness and deception is bad for business and something the industry has been working for years to improve. Therefore, there is some real potential of the construction industry returning to the dark ages.
On one hand, the return to something more like the Master Builder concept protects owners from process inefficiencies and contractors playing games that add cost to the project and the risk of going over budget and schedule. At the same time, the move to using more design-build, CM/ GC and IPD, and generally bringing the contractors and all service providers to the table prior to design and construction can reduce risk and improve project success for all involved. Not all owners, nor all contractors, are ready for this, but for larger, complex projects, this is the future-or what appears to be one of the best possible futures-for the industry and one that ultimately can be more effective in reducing costs.
Changing for the Future
As we work our way out of the Great Recession, owners that have projects to build will continue to want the lowest price and best value. There appears to be a growing bifurcation in the market, just as we see in the economy in general. Those in the middle will be squeezed the most. So what can contractors do to survive and thrive in this future? The fact is that there are contractors making reasonable profits even in the downturn.
The following is a list of areas that are yielding benefits for contractors:
- Become more strategic: If owners have more information about the contractors and construction process, contractors need to have more information about their potential customers. At the same time, contractors need a deeper understanding of their own processes, methods and all costs.
- Build closer relationships with customers: This isn’t just a matter of a salesperson taking the customer out to dinner or playing golf anymore. Buyers need to have confidence in their contractors. They need better ideas of how to accomplish their goals. Contractors must understand those needs and more, long before estimating and bidding a job.
- Develop IT as a profit center: The goal here is to make the IT department a profit center, not just a group that fixes computers and installs new software. Project management, productivity tools and tracking software for job progress and cost reporting will help
get waste out of the system and reduce costs. Understanding and using BIM has become a necessity rather than just a nice-to-have gimmick. Improved communication in the form of software and hardware from smart phones and tablets to jobsite cameras and regular discussions among project managers, the field and clients will not only help build relationships, but also reduce the time it takes to get things done. Even installing and making full use of a CRM system will help track business development efforts and customer information.
- Be specialists in strategic market niches: To avoid being more like a seller of commodities, become best-in-class specialists. Best-of-class contractors know their customers’ business and add value. While most forecasts and market discussion consider broader construction markets, there are many submarkets and market niches that can
be profitable. Thinking strategically, a contractor may even be able to carve out its own market niche with few competitors.
- Self-perform more work: Self-performing contractors are often the most profitable. They offer benefits to customers in having more control over schedule, price and quality and,
if they are productive, can make greater margins with their own labor. As labor shortages return with the economy, those companies that can best recruit, manage and mobilize labor will have the edge.
- Know how to innovate, accept and manage risk: The modern trend in business has been to avoid as much risk as possible by shifting it contractually or otherwise to others-who in turn move it on to others and so on. While it is important to avoid risk, the cost of shifting risk can be expensive. More contractors are working to get a deeper understanding of all the sources of risk in their work and, wherever possible, accept and manage the risk themselves. When done effectively, risk management can become another profit center.
- Embrace change: Most of the firms that were surprised by market changes were either not paying attention or ignoring what they knew was happening. Sometimes one has to believe his or her own eyes and data and make the necessary changes to adjust to market forces. In a recent paper by FMI, “Adjust, Adapt, Act: Winning Stories from the Post-
2007 Construction Industry,” Michael Vickery, senior vice president of BakerTriangle, is quoted as saying, “If as a company we were positioned today the same as five years ago, we were either wrong then or are wrong now, because the market is uniquely different.” It is important to have a company culture and a reputable company history, but if the firm is to have a great future, it has to make changes. Recognizing those needed changes early can mean the difference between a competitive edge and falling in line with the low bidders.
- Become productivity experts:The construction industry is often chided as being unproductive and behind the curve of high-tech manufacturing sectors. However, more contractors are breaking out of that mold and looking for ways to employ technology and processes like BIM, prefabrication and modularization to gain on productivity, safety and workforce changes.
- Be greener: It is not only important to understand owner needs and wants for more sustainable projects, but it is also time that contractors learn how to be more sustainable in their own business. Reducing waste and carbon footprint will not only provide a good example for others, but also reduce cost in a world where key materials are becoming scarcer and regulations stricter.
- Be collaborative and service-oriented: While it seems to go against the grain of low bid, price-slashing markets, thinking more like partners and service providers will be an advantage over time.
Be the Future of Construction not the Past
It does not take a crystal ball to see that the world will not return to pre-2007 conditions. It has been and continues to be a tough recession, and memories are not so short that we will see a credit-fueled building boom anywhere on the horizon. There are many trends and economic forces that are here to stay: sustainability and green construction, reduction of energy use, industrial technology use, consumer buying power and the Internet consumer market, scarcity of raw materials, and growing populations.
The beginning of the recession saw many companies hunkering down to try to wait it out; others saw opportunities for change. Competition will continue to be fierce, especially for those who follow the crowd and get in line. Owners will continue to be demanding, although we expect more will return to best value based on qualifications and experience rather than just low, low prices.
The thriving contractors of the future are dynamic innovators in all aspects of their business, making them attractive partners for the owners who need, want and value professional construction services.